News Room

HFTs: Juvenile Delinquents, or Misunderstood Youth?

Apr 16, 2013

Although high-frequency trading has been around for more than two decades, many people outside the Wall Street community (and even some industry insiders) still view it as a new and brash way to do business. That's why the recent news that the FBI and SEC are teaming up to look into high-frequency traders (HFTs) brought to mind the following question: Are HFTs the market's equivalent of juvenile delinquents who need to be handcuffed? Or are they merely excitable youths whose high energy needs to be channeled toward positive ends?

Bad boys, or misunderstood kids? And what should be done about them? These are key questions the industry needs to answer. If we don't, other interested but less-qualified parties – such as Congress, regulators, and law enforcement – will answer them for us, in ways we probably won't like.

It's clear that the self-policing the industry has done to date with HFTs and algorithmic – or 'algo' – trading isn't enough. Various authorities and regulators on both sides of the Atlantic want to know if HFTs are damaging markets with excessive volatility and hurting ordinary investors through market manipulation.

HFTs are now on the radar screen of the Financial Stability Oversight Council, the cross-agency group and top U.S. regulators that examine systemic risks. A recent report by the Council cited concerns that high-frequency trading "could lead to unintended errors cascading through the financial system." In addition, the CFTC's former chief economist concluded in a recent study that HFTs are reaping profits at the expense of traditional investors in the US and internationally.

With regulators obviously circling, why hasn't the industry come up with its own solution to the HFT conundrum? The short answer is that it's complicated. In fact, it's so complicated that some of the smartest and most experienced people in the business come down on opposite sides of the issue.

Critics say HFTs' speed gives them unfair advantages over traditional investors. They also say HFTs are key players in destabilizing events such as the "flash crash" of May 2010. Seth Merrin, CEO of Liquidnet, put it this way: "High-frequency trading benefits the very few at the expense of the very many, which defies the purpose of why a market exists and as a result has lessened the overall quality of the markets."

On the flip side, HFT has its supporters. They point to studies that show that HFTs create more competition, bring neededliquidity to decreased trading volumes, and reduce trading costs for all investors. Gus Sauter, the former chief investment officer for Vanguard Funds, said: "The lion's share of high frequency works to the benefit of the marketplace. It provides liquidity to the marketplace. It provides tighter spreads than we would experience otherwise."

So what's the verdict on HFTs? Innocent, or guilty as charged?

We at Kuberre Systems think that both sides are right. We believe that an effective solution lies somewhere in the middle. High-frequency trading systems are tools that can be used to benefit markets and investors of all kinds. But as is the case with all powerful tools, the potential exists for people to misuse them. Powerful tools need controls. Without appropriate risk controls, people and markets can get into trouble unknowingly and very quickly due to runaway algos. That is the issue our industry must address. We must self regulate to avoid having government agencies create overly aggressive regulations that would discourage the growth and beneficial development of HFT.

What is the best path forward? Banning these systems won't work; it would only drive them into darker and less-regulated corners of the markets. Enter Nucky Thompson (of Boardwalk Empire fame): "Prohibition anyone?" And controlling them with things like a 'minimum quote life' won't work either, because those types of measures tend to create uneven playing fields. Hitting HFTs with 'micro-taxes' would create a drag on the market, which is the last thing it needs in this struggling recovery. None of these ideas are likely to materialize soon, in any case, because regulators continue to struggle with figuring out whether HFTs are fundamentally good or bad.

How, then, can the industry ensure proper use of HFT and algo systems, and avoid misuse? The answer is innovation. Specifically, we need more development of next-generation pre-and post-trade risk control systems. The industry also needs to look at the HFT challenge from a new perspective.

Ultrafast trading and high-performance risk controls need not be mutually exclusive. Quite the opposite, in fact -- they should operate in tandem. HFT and algo systems should always be accompanied by equally powerful and intelligent risk control systems. And given the nature of these runaway trading incidents, the solution should be focused on the order side, with stronger pre-trade controls and, if required, supplemented with post-trade-side drop copy reconciliation.

The benefits of capabilities that will put risk control on an equal footing with faster trading include the ability to operate remotely, not just locally. These trading platforms need precise, independent and ultrafast trading 'kill switches' that can be activated from afar (but not installed/operated and monitored by exchanges). They need to provide a firm's chief risk officer with automated and granular ways to set and monitor risk parameters by instrument, desk, and department, and give that person the ability to take lightning-fast action – remotely – when those parameters are exceeded.

When risk managers have systems that can spot a problem anywhere within their geographically dispersed trading operations, and shut it down before the next order is sent – in less than a microsecond – then there will be harmony in HFT. To achieve this harmony, the key is to look at the problem as a series of workflow components that need to be tightly integrated and gives traders the flexibility and speed they require, but that also yields full risk control to the risk officer. That is the essence of the solution.

So let's not wait for the next Knight incident or sit idly by while the authorities round up the usual HFT suspects for mug shots and lineups. The systems described above are not science fiction; they exist today. By beginning to implement them now, the industry will demonstrate to law enforcement and regulators that we can police our own. We must control our unruly HFT 'child,' because we don't want to lose "custody" or, worse, have HFT grow up to become the industry's wild child.

Source: Originally Appeared on TabbFORUM